Speech The Current Economic Landscape

I would like to thank CEDA for the invitation to be part of this panel today. It
is a pleasure to be here. As you may know, the Reserve Bank recently released
its latest Statement on Monetary Policy. This morning, I would like to pick up
on three of the main themes discussed in that document. These are: the two-speed
global recovery; the resilience of the Australian economy; and the moderation
of inflation in Australia.

The World Economy

A year ago when this conference was held, the world economy looked to be standing
on the edge of a precipice. Output was contracting, international trade was
collapsing, consumer and business confidence were falling, and risk aversion
was extreme. At the time, many serious observers were talking about the possibility
of a rerun of the problems of the 1930s.

As we now know, the world economy moved back from the precipice. Global output grew
by around 3 per cent over the final nine months of last year, international
trade has recovered some of its earlier falls, confidence has improved somewhat,
and risk aversion has abated. As a result, many observers are now predicting
that global growth will be around 4 per cent this year and next – a much
better outcome than that feared likely a year ago.

One reason that we have moved back from the edge is the policy responses of governments
and central banks. These responses provided the public with the assurance that
policy makers would not stand idly by. Collectively, they were sufficient to
interrupt the corrosive cycle of falling confidence undermining spending, then
feeding through to even lower confidence and even lower spending.

The pick-up in the global economy has, however, been quite uneven. In the advanced
economies, the recovery to date has been weak, especially in light of the very
large contractions in output that occurred. In contrast, in Asia the bounce
back has been much stronger, with many of the economies in the region growing
solidly and operating with much less spare capacity. Looking forward, this
two-speed world is likely to continue for some time yet.

In the advanced economies, growth has generally returned, although this has much
to do with the dynamics of the inventory cycle and the boost to spending from
temporary fiscal measures. While it is not unusual that these factors play
a major role in the early part of a recovery, a stronger pick-up in private
demand than has occurred to date will be needed for a self-sustaining recovery
to take hold. In many countries, both consumption and investment are still
very weak, with individuals and businesses remaining very cautious (Graph 1).

Graph 1

Looking forward, the central scenario for most of these economies remains a subdued
recovery. It is likely that many of them will continue to be weighed down by
the desire of households to reduce leverage and increase savings. And with
considerable excess capacity, a strong recovery in business investment also
appears unlikely, at least in the near term. Many of the advanced economies
have weak financial sectors with little appetite for risk. Many also face very
significant medium-term fiscal challenges that need to be addressed. If history
is any guide, overcoming these various balance-sheet headwinds will take considerable
time.

The picture in Asia is very different. A number of economies have had near V-shaped
recoveries; this is particularly evident in the data for industrial production
and trade (Graph 2). Unemployment is coming down and, unlike in the advanced
economies, core inflation has troughed and is starting to increase. Throughout
the region, the stimulatory settings of both monetary and fiscal policy that
were put in place have proved to be an effective antidote to the problems emanating
from the major North Atlantic countries. The region has also avoided the financial
headwinds created by a troubled financial sector and high levels of public
debt.

Graph 2

The recovery has been strongest in China, with the economy growing by 8¾ per cent
last year. This strong growth has also provided a boost to many other economies
in Asia and beyond, with Chinese imports having increased rapidly (Graph 3).
In the middle part of the year, the growth in China was driven by a surge in
public-sector infrastructure, but more recently there has been some rebalancing,
with exports and consumption rising strongly.

Graph 3

The challenges facing China are obviously different from those facing the advanced
economies. Foremost amongst these is deciding how, and when, to scale back
some of the policy stimulus that was put in place. As many observers have noted,
if stimulatory policy settings remain in place for too long, there is a risk
of overheating, leading to difficulties down the track. But calibrating the
withdrawal of the stimulus is difficult and there are clearly risks in both
directions. On balance, it is plausible to argue that the recent tightening
in credit conditions is a favourable development in that it increases the likelihood
that the Chinese economy is on a sustainable path. Time will tell though.

This two-speed world presents a very interesting backdrop for the Australian economy.
There remains some risk that developments in the advanced economies could again
derail growth in the global economy. But the more likely scenario remains a
relatively subdued recovery in the advanced economies and stronger growth in
Asia, with domestic demand in the region making a greater contribution to growth
than has been the case historically.

If this is how things play out, the Australian economy is well placed. Around 70 per cent
of our exports now go to Asia and the strong growth in the region has supported
commodity prices. This is reflected in our terms of trade, which are likely
to increase strongly over the next year from what is an already high level
(Graph 4).

Graph 4

Domestic Developments

This brings me to my second theme – the general resilience of the Australian
economy.

Amongst the advanced economies, Australia is the only one to have avoided a negative
year-ended growth rate during the global downturn. While activity did contract
in the final quarter of 2008, it is likely to have grown by around 2 per cent
in 2009.

This is a considerably better outcome than thought likely a year ago and it has led
the Bank to revise up its forecasts for growth for 2010 and 2011. Most of this
upward revision occurred between mid last year and November, with only very
modest revisions since then. Our central forecast is for the economy to grow
by around 3¼ to 3½ per cent over each of the next couple of years
(Graph 5). This is slightly above the average of the past two decades
and, if it occurred, would likely see a gradual reduction in the spare capacity
that currently exists.

Graph 5

This outlook is based on a judgment that growth in private demand will gradually
strengthen, with public demand providing support to economic activity in the
short term. The housing sector is now firmly in the upswing phase of the construction
cycle, and increased investment in the resources sector over coming years is
expected to see investment, as a share of GDP, return to the very high levels
seen in late 2008. In terms of consumption, we are expecting reasonably solid
growth, although below the pace of earlier years as households continue to
take a more cautious approach to their finances.

There is one technical issue regarding these forecasts that I would like to draw
your attention to – that is the assumption about interest rates used
by the Bank's staff when putting these forecasts together. For some years,
it had been our practice to produce forecasts assuming that the cash rate remained
unchanged throughout the forecast horizon. This approach had the obvious advantage
of simplicity, but when the cash rate is a long way from its normal level,
it is not particularly realistic.

So, in August last year we changed our approach. Since then, we have prepared our
forecasts on the technical assumption that the cash rate returns towards a
more normal setting over time. Our overall objective here is to provide the
community with a general sense of how we think the economy is likely to evolve
over the next few years and to do this we need to make realistic assumptions.
Broadly speaking, the paths the staff have used have been similar to those
implied by market interest rates at the time the forecasts were prepared. It
is important to stress that this neither implies a commitment by the Board
to the particular path used nor an endorsement by the Bank of the market pricing.

One aspect of our recent economic performance that particularly stands out is the
solid performance of the labour market, with the unemployment rate having peaked
at 5¾ per cent (Graph 6).

Graph 6

This is clearly a much better result than earlier thought likely and it has been
important in underpinning a high level of confidence in the community. In turn,
this has helped short circuit what could have been a damaging dynamic –
that is, rising unemployment feeding through to weak confidence and lower incomes,
in turn feeding through into lower spending and a further increase in unemployment.
There are a number of factors that have helped here, but the one that I would
like to highlight today is the greater flexibility of the labour market.

In previous economic slowdowns, when the demand for labour declined, people lost
their jobs almost one for one with the decline in labour demand. On this occasion,
things turned out quite differently, with the increase in the unemployment
rate being smaller than suggested by historical relationships between output
and employment. Partly this was because many firms and their employees agreed
to reduce working hours rather than to reduce the number of people employed.
In other cases, there was an agreement that wage increases would be reduced
or delayed as a way of preserving jobs. The good news is that this flexibility
in employment relationships worked in limiting job losses in the economy. This
has had obvious social benefits as well as supporting overall confidence in
the community. Without this flexibility, it is likely that the outcomes would
not have been as favourable.

In looking forward, there are number of issues that deserve particularly close analysis
as we gauge the current pulse of the economy. I would like to touch briefly
on three of these.

The first is the weakness in business credit. Over the past year, business credit
has fallen by 7 per cent (Graph 7). The last time we saw this type
of outcome was in the early 1990s, when the economy was in a deep recession
and investment was collapsing.

Graph 7

Making an assessment of why this contraction is occurring is difficult, but in all
probability the weakness reflects both supply and demand factors. In the commercial
property area, the supply of finance remains constrained with many lenders
having little appetite to increase their commercial property lending. On the
other hand, the demand for loans by many businesses in the broader economy
appears to have declined. Many firms have used equity raisings and/or their
cash reserves to pay down debt and, as a result, the rate at which loans are
being repaid is historically high (Graph 8). Over time, as the economy
strengthens and investment picks up, a reversal of these trends would be expected.

Graph 8

The second issue is the evidence of ongoing cautiousness by both households and businesses
at a time when confidence is reported to be very high. This cautiousness can
be seen not only in business credit figures, but also in household spending
decisions and in surveys of firms' investment plans (Graph 9). It
appears that one legacy of the global downturn is that many people, despite
being generally confident about the future, are taking a more conservative
approach to their spending. As we go forward, one of the things that will shape
how the economy evolves is how these attitudes change.

Graph 9

The third issue is the extent to which the timing of expenditure has been affected
by temporary fiscal measures. Through much of last year, a question that was
frequently asked, both in Australia and elsewhere, was whether the signs of
recovery primarily reflected temporary fiscal measures. One concern was that
some of these measures were simply bringing forward the timing of expenditure,
and that once this bring-forward was complete, spending would again decline.
A related concern was the possibility that spending might also weaken when
the temporary boost to income from various fiscal transfers was not repeated.

Around the world, it is clear that temporary incentives or payments have had significant
effects on spending patterns: the various car scrappage schemes are perhaps
the best example of this. In Australia, we have also seen some of these effects,
particularly with the increased first-home owners' grants and temporary
tax deductions for business investment. The latter, for example, has had a
significant effect on vehicle sales to businesses (Graph 10).

Graph 10

Looking forward, there remains some possibility that, with these measures now having
been wound back, activity could again slow. However, as time has passed, the
likelihood of this being the case has declined. Household consumption held
up better than expected over the second half of 2009 after the fading of the
effects of the earlier cash payments. Over recent months, there is some evidence
to suggest that the purchase of various services by the household sector has
been particularly strong with, for example, a marked increase in spending on
restaurants, cafes and take-away food (Graph 11). This is unlikely to
be related directly to temporary fiscal measures. More broadly, the expansion
of the resources sector and the improvement in the terms of trade reflect structural
developments in the world economy, rather than temporary policy measures in
Australia.

Graph 11

Inflation

The third area that I would like to touch on is the moderation in inflation that
has occurred in Australia.

If we go back to the September quarter 2008, the year-ended inflation rate in underlying
terms was running at a little over 4½ per cent. It is now around 3¼
per cent, with the outcome for the December quarter around 0.6 per cent,
a marked step down from rates in previous quarters. This moderation is in line
with what we had been expecting for some time.

This reduction in inflation reflects three main factors: a slowing in wage growth
in the private sector; the appreciation of the exchange rate; and an increase
in spare capacity in the economy. These factors all take time to fully work
their way through, so we expect a further period of modest quarterly outcomes
and thus further moderation in the year-ended inflation rate.

One issue that has attracted some attention lately is how the Bank assesses the rate
of underlying inflation. Here, it is important to point out that we do not
have a mechanical approach. What we are trying to do is to discern the average
rate of increase in prices, abstracting from particularly unusual movements.

At any point in time, we are looking at the whole range of price changes in the economy
and using various analytical techniques to derive measures of central tendency.
Inevitably, these different measures produce slightly different outcomes, but
they show the same general patterns over time (Graph 12). Since there
is no single unambiguously ‘right’ measure, we look at them all.
Then, using all the information at our disposal, we make our general assessment
of the rate of underlying inflation.

Graph 12

We do all this because we have found it a useful input into thinking about how CPI
inflation – which after all is our objective – is likely to evolve
over time. As we go through the process of putting our inflation forecasts
together, understanding recent price pressures in the economy is important,
and we have found looking at the various measures of underlying inflation helpful
in this process. But to emphasise again, our focus here is very much a forward-looking
one.

Our latest inflation forecasts were set out a few weeks ago in the Statement on Monetary Policy. We expect that CPI inflation will be
around 2½ per cent in 2010 and just a little higher in 2011 (Graph 13).
These forecasts represent small upward revisions to those set out three months
ago, largely reflecting the fact that the economy looks to have less spare
capacity than earlier thought likely.

Graph 13

Concluding Remarks

Overall, the Australian economy finds itself in a much better position than the other
advanced economies. We have come through the global downturn better than expected
and, unlike many other advanced economies, employment has recently grown strongly
and the level of investment remains high. We are benefiting from high commodity
prices and from our links with Asia. Inflation is moderating, and is expected
to be consistent with the medium-term target over the next couple of years.

Risks of course remain, both in the advanced economies and in Asia. But the central
scenario for Australia over the next few years remains a positive one, with
the challenges that we are likely to face being quite different from those
facing the other advanced economies.